America's bond market is crushing it

Fixed income markets in the United States have been on an amazing bull run over the last 36 years since Treasury yields peaked north of 15 percent in 1981. This upward market refuses to die easily despite repeated warnings to investors that bonds are a terrible investment with interest rates set to move only one direction, and that is higher.

Following the Republican sweep last November, Treasury yields quickly spiked and bond bears finally appeared ready for vindication. Instead, potential threats to fixed income markets in the form of economy boosting fiscal stimulus and trade protectionism under the Trump administration still have yet to materialize. Treasury yields over the long term moved lower after the 2016 election, and fixed income markets are on track to deliver another year of positive returns for investors.

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Even without anticipated fiscal stimulus, the Federal Reserve is staying the course to normalize interest rate policy in the United States. It hiked rates in March and June and has raised rates four times in the past two years. The Fed is also just beginning the well-telegraphed process of winding down its $4.5 trillion balance sheet of U.S. Treasury bonds and mortgage-backed securities. Gradual tightening of policy is continuing despite U.S. inflation recently trending lower.

Further, almost every measure of inflation is currently below the Fed’s target of 2 percent. The growth of the Fed’s favorite inflation gauge, core personal consumption expenditures, has slowed considerably to just 1.3 percent year over year. Persistent low inflation with the economy nearing full employment flies in the face of traditional economic modeling and is leading to a growing disagreement among Fed policymakers about the course of future policy.

Disagreements over easy money policies are not limited to current Fed members. Since first implementing unprecedented monetary policy tools in the midst of the worst economic crisis since the Great Depression, the Fed has been accused of manipulating interest rates and distorting the market’s ability to price financial assets. The narrative suggests financial markets will eventually pay for the Fed’s misdeeds, most likely in the form of higher inflation and currency devaluation.

Even Kevin Warsh, a former Fed governor and possible candidate to replace Janet Yellen, has accused central banks of “aiding and abetting” rising global asset prices through aggressive quantitative easing. With vacancies mounting at the Fed and growing doubts among those left on the board about the usefulness of traditional economic modeling, President Trump’s choice to head up the Fed next year takes on even more significance.

As the bond bull market keeps running, investors should focus on several factors.A flattening yield curve implies growing concerns among investors about the sustainability of economic growth and whether inflation may ever take hold. A flatter yield curve also has negative implications for financial stocks as interest margins compress. The yield curve has flattened this year and recently touched the lowest point since the financial crisis. Continued flattening is a sign Fed policy has become too tight and adds more fuel to keep the bond bull running.

The absence of inflationary pressures even as labor market conditions tighten has perplexed economists inside and outside the central bank. Structural forces for disinflation, such as technology, globalization, aging demographics and excess leverage, have overwhelmed cyclical inflation pressures. If inflation expectations eventually pick up, bond yields will move higher in tandem.

The bond market’s resilience to quantitative easing ending in the United States can partly be explained by the reach for yield from global investors with nowhere else to go. With $8 trillion in global bonds still trading at negative yields, transitioning from unprecedented levels of monetary stimulus in Europe and Japan poses risk to the Treasury bond market.

A common refrain for stock market investors and often the economy broadly is “gridlock is good.” Following the steep sell-off in the bond market after Trump’s victory last year, the same should be said for the bond market today. Inflation pressures are likely to build with excessive fiscal stimulus or protectionist trade policies under consideration by the Trump administration.

Bond markets in the United States continue to defy skeptics and deliver steady, if not spectacular, results. While the expectation for higher yields will most certainly remain the consensus as we move into 2018, these bond market indicators should give investors clues about potential risks to the long running bond bull market.

Mark Heppenstall, CFA, is chief investment officer at Penn Mutual Asset Management. He has spent more than 25 years managing assets for institutional investors.